Think you're an independent contractor because you're
homebased? Think again. Telling an independent contractor from an
employee is about as easy as keeping identical twins straight. And
if you're wrong, you may have broken dozens of laws and be
forced to pay large fines.

Many companies love independent contractors. By hiring
freelancers, businesses avoid salaries, benefits, labor laws,
workers' compensation premiums, payroll and unemployment taxes,
having to supply office space and equipment, and responsibility for
most worker negligence. On the flip side, the independent
contractor is typically glad to trade job security for the freedom
of being his or her own boss. Generally, independent contractors
make 20 percent to 40 percent more than they would as employees.
And because they're not subject to withholding, they keep more
of their money longer. At tax time, they get to take
business-related deductions.

The IRS, claiming it's losing billions of dollars each year
due to employers who misclassify their employees as independents,
is cracking down. The problem is, the definition of independent
contractor under current law is complex. Businesspeople aren't
sure what they can and cannot do, and the IRS has aggressively
exploited the gray areas to its advantage.

Under basic legal principles, the hiring company's degree of
control is what distinguishes the freelancer from the "wage
slave." An employer can tell an employee not only what it
wants done but also how to do it. With an independent contractor,
however, the employer specifies only the ends, not the means. As
you might suspect, these tests are too general to be useful. More
than 50 years ago, even the U.S. Supreme Court admitted it had
trouble applying them. As you'll see, little has changed.

First, Congress tried to help. In 1978, it enacted safe harbor
laws (Section 530) to protect employers who had reason to classify
their workers as independent contractors, had filed their returns
and were consistent in how they differentiated their workers.
Although these laws are helpful and have been clarified by
amendments several times, most recently by the Small Business
Job Protection Act of 1996, they have not eliminated the
problem.

Then, in 1987, the IRS tried to help. Poring
over court cases and tax rulings, it cooked up a test
to clarify
employer-employee relationships . . . a
test with 20 ambiguous considerations.

Thus, when the IRS audits a business owner on this issue, nine
times out of 10, the businessperson loses. That can mean
disastrous retroactive payments of Social
Security, Medicare, unemployment and income taxes--plus
interest and penalties. In fact, it's been estimated that since
the mid-1980s, the IRS has reclassified 439,000 workers, pocketing
more than $678 million as of mid-1996.

And what if you are the independent contractor who is
reclassified as an employee? You'll suffer too, potentially
losing your home office, pension plan and other
business deductions, not to mention income should the
"employer" find you too expensive to keep as a
freelancer.

Marc Diener is an attorney in Los Angeles. This article contains
general information only. If you are concerned about how these
issues might affect you, seek independent counsel.

And That's Not All

When freelancers at Microsoft were reclassified
as employees, they sued for retroactive retirement benefits.
The reclassification of an injured worker may trigger substantial
fines under workers' compensation laws and liability for
medical bills and lost wages. Misclassification can even mean
criminal penalties under the Fair Labor Standards Act. And if this
isn't complicated enough, various agencies and states use
different tests to sort their workers. Thus, a worker may be
an independent contractor under one law and an employee under
another.

Protect Yourself

Despite specific IRS programs to achieve greater consistency and
efficiency and congressional attempts to replace the 20-part test,
worker classification issues will continue to plague business
owners for a while. As we've seen, simply christening a worker
an independent contractor won't protect an employer. And for
those who consider themselves independent contractors, a home
office by itself means little, especially in our age of easy travel
and telecommuting, and particularly in the new training manuals
developed for IRS agents policing this area. Still, no matter which
side of this equation you're on, you can reduce the risk of
reclassification. Here are five strategies that may help you
survive an IRS challenge:

1. Plan to use the safe harbor. According to
attorney Stephen Fishman, author of Wage Slave No More: The
Independxent Contractor's Legal Guide (Nolo Press),
it's now easier for businesses to take advantage of Section
530, especially if they plan ahead. For example, a company may
establish its "reasonable basis" for treating workers as
independents by taking a survey to determine, and then conform to,
widespread and long-standing practice in its particular industry.
It could also obtain, and rely on, the formal opinion of a lawyer
or accountant knowledgeable in this area.

2. Let the independent stay in control. A hiring
business shouldn't try to tell an independent how to get the
job done. Freelancers should not receive training, have set hours
or procedures, or have reporting requirements. Independents should
be able to delegate duties freely and hire their own
assistants.

3. Structure compensation correctly. An independent
should bear the risk of profit or loss. Accordingly, they're
best off invoicing their employers per job rather than per hour,
per day or per week. Freelancers should receive no benefits or
expense reimbursements. Employers should report payments to
independent contractors on IRS Form 1099. It also helps to
have checks made payable to a company or a dba, or to have the
independent contractor incorporate.

4. Hire (or be) a self-reliant contractor.
Freelancers should have their own offices, supply their own
equipment, pay their own taxes, have their own insurance, work for
more than one client, do their own marketing and advertising, and
not be integrated into the general business operations of their
clients.

5. Have a written contract. Although structuring
these relationships correctly is crucial, documenting them also
helps. Restate the above elements in your formal agreements.
Specify that neither party has the right to terminate the deal
unless the other fails to live up to its obligations. Add a
statement that one party intends the other to be an
independent contractor and not an employee. Don't forget
to add a provision regarding the ownership of any copyrights or
other intellectual property (patents, trademarks or trade secrets)
created during the engagement. "In a close case, a written
agreement may tip the balance," says Fishman.

Generally, determining independent contractor status is the
employer's headache. In addition to the above, employers should
keep accurate records to justify their classifications and
establish consistent policies. On the other hand, if you're
freelancing, use these guidelines to make your prospective client
feel as comfortable as possible about hiring you as an independent
contractor. This war of independents is far from over.